By Matt Wirz 

Russia's markets reacted modestly to U.S. sanctions last week, but the country's bonds have been weakening for months, indicating that for investors, geopolitical pressure is outweighing the country's economic strength.

The sanctions announced April 15 bars U.S. banks and institutional investors from buying new Russian government ruble-denominated bonds at auction. The response to Russia's alleged cyberattacks and election interference is part of a broader strategy by the Biden administration to pressure Russia financially. The U.S. in March released an intelligence report on the alleged election meddling and has stepped up trade sanctions for Russia's alleged use of chemical weapons.

The new measures stopped short of prohibiting purchases of Russian government bonds in the open market, a step investors and analysts said would have had a much greater chilling effect. Still, the diplomatic campaign has coincided with an increase in Russian bond yields and a relatively modest decline in the ruble, boosting the Russian government's funding costs.

The deterioration of Russia's bonds and its currency bucked the expectations of some Wall Street banks, which had predicted that Russia's strong balance sheet would help it outperform other emerging-market countries in 2021. Russia had low net debt relative to its gross domestic product, according to data from S&P Global Ratings, and analysts took comfort in the government's commitment to conservative fiscal policy.

"The only reason any of the bonds trade with a risk premium is because of the risk of sanctions and the possibility they'll escalate from here, " said Grant Webster, a portfolio manager who helps invest about $4.5 billion in emerging-market debt at Ninety One PLC. One of the mutual funds Mr. Webster co-manages reduced its allocation to Russian government bonds to 3.65% in February from 4.54% in January, according to data from Morningstar Inc.

The yield on Russia's 10-year government debt was just above 7% last week, relatively unchanged from before the new sanctions but about 1.1 percentage points higher than at the start of the year, according to data from FactSet. The rise in short-term rates has been more pronounced, with the two-year yield hovering around 5.49%, compared with approximately 4.42% at the end of December. A spokesperson for the Russian finance ministry couldn't be reached for comment.

Russia has slid to the 18th-largest component of a widely followed BlackRock Inc. exchange-traded fund invested in emerging-market local-currency bonds, from fifth in October, according to marketing materials for the fund.

Demand for the ruble might be waning as a result of the sanctions. Heightened risk in Russia could have prompted investors to sell the currency last week to buy the South African rand, according to research by Morgan Stanley. Analysts at the bank changed their recommendation on Russian interest-rate trades to "neutral" from "like" based on expectations of a rate increase later this month.

Investment banks were bullish on Russia coming into 2021, in large part because of actions its government had taken to defend against financial pressure from the U.S. and Europe. Bank of America ranked Russia as the best of the big emerging-market countries in a December report, citing its "large positive net foreign assets, the lowest public debt, a small fiscal deficit and even a current account surplus -- despite low oil prices."

Oil is Russia's biggest export, and the price of Brent crude has risen about 29% this year. Yet the country's bonds have underperformed. That is primarily because of potential U.S. sanctions, said Tim Ash, a bond strategist at London-based investment firm BlueBay Asset Management. The new restrictions set the stage for a further ban on U.S. institutions' trading Russian debt in secondary markets if tension between Moscow and Washington intensifies, he said.

"You have to expect more sanctions," he said.

The U.S. has gradually restricted investors' trading in Russian debt. The Trump administration imposed sanctions in 2018 barring U.S. entities from buying debt of some companies and individuals with ties to the Kremlin in retaliation for alleged election interference and hacking. The following year the ban was expanded to purchases of new Russian government bonds issued in foreign currencies, such as the dollar or euro.

The next step would be to start limiting trading of existing debt, Mr. Webster said. "I don't think chances of that are very high right now, but it's totally still on the table," he said. "They have started drawing the dots, and that's the next dot."

Write to Matt Wirz at matthieu.wirz@wsj.com

(END) Dow Jones Newswires

April 19, 2021 08:14 ET (12:14 GMT)

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